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QUOTE OF THE WEEK

"In our view, investment students need only two well-taught courses: 1) How to Value a Business, and 2) How to Think about Market Prices."

– Warren Buffett

Read more of our favorite value-investing quotes.

 


JUNE 24, 2015

 


IN THIS EDITION:
- How to Think about Market Prices
- Are Stock Prices Random?
- Not Random At All
- Identifying Points Of Likely Upturn And Downturn
- How To Profit From The Signals
- Why Are Value Stocks Struggling?
- Where Are Stocks Headed Now?

 

 

 


"2) How to Think about Market Prices."

 

This week I am going to address the second part of Warren Buffett's famous advice that investment students need only two well-taught courses. The first course America's famous billionaire value-investor recommends is 'How to Value a Business' and the second course is 'How to Think About Market Prices.' 

By the end of this article, you will learn a bit about how to think about market prices, have an basic understanding of why the market makes big swings, see how to know in advance when the turn points are going to occur, and where the market currently stands relative to value investing in the next few weeks. There is information on this page that will benefit beginner and experienced investors alike.

 

To discuss how to think about market prices, we are going to enter into an area that many value investors consider to be blasphemy: technical analysis. However, when one of the world's wealthiest human beings (as a result of successful investing) speaks, the rest of us wannabe successful billionaire investors should pay attention.

While your first thought may be that Mr. Buffett was not talking about technical analysis (TA), market prices are the precise focus of TA. IntelligentValue is dedicated to providing you with a modern approach to classic value investing. In our opinion, that approach includes enhancing our decision-making about undervalued stock purchases using technical analysis. TA can help determine when market prices have come to you, rather than making a guess about whether or not the undervalued condition of a stock is ripe for harvesting. 

Old-school, classic value investing (the kind Warren Buffett practices) involves purchasing a stock and holding it for 5, 10, or even 20 years before it might obtain full value. Our vision of a modern approach to value investing, one enhanced by technical analysis, concerns purchasing a stock when it is not only undervalued but primed for gains from a technical standpoint. It is also about selling when the stock's (or the overall market's) trend has played out.

For our two value-based portfolios, that involves an average hold time of 4 to 6 months with an average return of about 40% per stock and minimal drawdowns (max @ 20%). That sounds much more reasonable than 5 or 10 years and simply guessing the appropriate time to enter and exit your positions, doesn't it?

We believe the other aspect of Mr. Buffett's advice to learn 'how to think about market prices' also has a lot to do with confidence; confidence about when to be "greedy when others are fearful, and fearful when others are greedy" (another of his famous suggestions for fellow investors). Technical analysis can provide you with that confidence. In this article, we will show you some examples of how you can attain that confidence.

ARE STOCK PRICES RANDOM?

Even though it may appear this way, the first thing we want to dispel is the notion that stock market prices are 'random.' It's not surprising that stock prices appear as a random fluctuation to many beginning investors.  For example, consider this four-year chart of the Russell 2000 (small-cap) index:

Random Prices?
CHART 1: RANDOM PRICES? Is the market simply a series of random price movements? It might appear that way to beginners (or academics).


It is easy to see from the chart above why many investing beginners would see no way to make sense of the wild price swings in the market. For example, in 2011 the Russell 2000 plummeted 24% from July to October. Then from June 2012 to March 2014, it skyrocketed an amazing 60%! That big gain was followed by a very volatile 13% downturn throughout 2014. However, in October 2014, the small-company index began a 26% run higher. How could you make heads or tails of those moves in advance? Is there any way of anticipating when to be in the market or out?  After all, it sure looks very random.

This notion that stock prices are random became common based on a book titled A Random Walk Down Wall Street, written by Burton Gordon Malkiel, a Princeton economist. The 12-edition, 1.5 million-selling book has been influential on the subject of stock markets and popularized the random walk hypothesis. The 'random walk' is a financial theory stating that stock market prices evolve in a random pattern and thus cannot be predicted. It is consistent with the efficient-market hypothesis (EMH).

 According to Wikipedia, "efficient-market hypothesis (EMH) states that it is impossible to 'beat the market' because stock market efficiency causes existing share prices always to incorporate and reflect all relevant information. According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments."

In essence, EMH postulates that fundamental analysis and technical analysis are futile pursuits. In 1984 at Columbia University, Warren Buffett (who has accumulated a personal wealth of more than $60 billion from value investing) gave a speech titled, The Superinvestors of Graham-and-Doddsville. Buffett's speech was a rebuttal of A Random Walk Down Wall Street and the Efficient Market Hypothesis. As Seth Klarman, another billionaire value investor, has stated: "Buffett's argument has never, to my knowledge, been addressed by the efficient-market theorists; they evidently prefer to continue to prove in theory what was refuted in practice."

On another occasion, Buffett also said (regarding EMH) that "the best possible opponent you could have on the other side of the table from you (in a stock price negotiation) is someone who believes it's useless to even try."

The EMH has become the basis of an elaborate lattice of academic studies chock-full of faulty thinking. This professor-generated framework includes the Efficient Market Hypothesis, Modern Portfolio Theory, the Capital Asset Pricing Model, beta (portfolio returns are dependent on risk incurred) and other such silliness. Who would you follow with a plan for investing your life savings: a bus full of professors who probably have never invested a dime of their own money or Warren Buffett and other billionaire value investors?  In the following paragraphs, I will show you exactly why this EMH/random walk logic is not only silly, but an unprofitable waste of trillions of dollars by investors who park their money in indices and hope for the best.

NOT RANDOM AT ALL

Seasoned investors, especially those with experience in technical analysis, know that the market is not random at all. While value drives the longer-term movements of the market and individual stocks, technical analysis frequently drives the short-term price action. 

To go from seeing the 'obviously' random movements of the market depicted in Chart 1 to seeing the clear patterns I'll show you below, is akin to the world, post-Galileo, coming to accept that the earth was not the center of the universe. It involves resetting our boundaries, our framing, our paradigm on the markets.

In the June 20 issue of the Intelligent Market Risk Analysis™ (IMRA) we identified how the Russell 1000 index (used for our RV Portfolio) dropped precisely to its Long-Term Trend Line last week, then bounced higher from it this week. In Chart 2 below, I'll show you another way to identify stock-price lower boundaries. In this case, we are displaying the Russell 2000 (small-cap) index moving precisely to four different moving-average lines:

NOT RANDOM AT ALL
CHART 2: NOT RANDOM AT ALL. T
his chart shows the Russell 2000 index with four support levels, the 20, 50, 100, and 150-week moving-average lines.


Why show so many lines? To demonstrate how the different moving-averages establish support for stock-price movements at various levels. For example, follow with your eyes along the top, blue, 20-week moving-average line (especially throughout 2013). Notice how the index bounces along that line, while occasionally dropping down below it to the red 50-week moving average or the green 100-week moving-average line. Back in October 2011, the Russell 2000 prices fell precisely to the 150-week moving-average line (on a closing basis) before bouncing sharply higher. If prices were random, we would not see such clear demarcation.

Moving average lines are used to identify areas of price congestion. Just as experienced fishermen know to fish in the patches of shade or around a sunken tree limb (because that is where the fish are congested), we want to drop our stock-selection 'line' in areas where stock prices get congested. By doing so, we are more likely to enter and exit near the location where changes of direction are likely to occur.  Ideally, that means buying at the point of a possible upturn, and selling at the end of a downturn (I will show you how to do both in a moment).

Technical analysis is scalable, so the same congestion points and support lines can be viewed on daily and even minute-based charts and on the other end of the spectrum, monthly charts. Generally speaking, traders use daily and minute-based charts while investors use weekly and monthly charts. IntelligentValue uses weekly charts because 1) we are intermediate-term value investors and do not need more frequent prices, and 2) weekly prices are much more accurate.

Many 'investors' are obsessed with the intra-day movements of prices, but with our system we not only do not look at intraday prices, we only view prices at the close of each week. By doing so, we avoid being whipsawed in and out of stocks by bad decision-making prompted by the schizophrenic rotisserie of 'experts' on CNBC and we also maintain a modicum of sanity.  By minimizing the number of decisions being made, we also avoid the problems of buying when greedy and selling when fearful.  In a world where mouse-click, instantaneous transactions are highly valued, we only look at stock prices when the markets are closed. We publish our newsletter, market analysis, and portfolio updates on the weekends.

IDENTIFYING POINTS OF LIKELY UPTURN AND DOWNTURN

We use a variety of technical analysis tools to help us identify points of likely upturn (market-related opportunity) and downturn (market-related risk).  These tools can be applied on the individual stock basis as well as on an overall market basis.  When used with either, we can enhance the points of investment entry or exit and dramatically increase returns.  Would you like to know how to put the big gains (shown in Chart 1, above) to work for you while moving to cash for the drawdowns? I'll demonstrate how to do that using a few tools of technical analysis we use in our weekly Intelligent Market Risk Analysis™, which is published each Saturday.

BOLLINGER BANDS

One tool we have used behind the scenes but are now going to be showing to Members each week are Bollinger Bands. According to StockCharts.com, which we use for our technical analysis, "Bollinger Bands® are volatility bands placed above and below a moving average. Volatility is based on the standard deviation, which changes as volatility increases and decreases. The bands automatically widen when volatility increases and narrow when volatility decreases."  Their creator, John Bollinger, found that stock prices tend to move within two standard deviations of a moving-average center line. The standard-setting for Bollinger Bands is two standard deviations around a 20-period moving average.

Again, we are using weekly charts, so the gray area around the stock prices show bands that are two standard deviations around a 20-week moving average:

Identifying Exreme Prices
CHART 3: Identifying Extreme Prices. Bollinger Bands help identify times when prices get extreme and are more likely to revert back in the opposite direction.

 

According to Bollinger, the gray bands shown above should contain 89% of price action, which makes a move outside the bands significant. The green arrows point to spots where the lower Bollinger Band was penetrated while the red arrows show spots where the upper band was penetrated. Notice that stock prices tend to revert in the opposite direction after a penetration. Therefore, the penetration outside a band is a good indication that there is a change of direction at hand.

Chart 4 (below) zooms in to highlight the middle of October 2014, where we can identify the last big buying opportunity from a penetration of the lower Bollinger Band and a drop precisely to the green 100-day moving average (support). That was a cannot-miss setup for a big move in prices higher. The next three weeks, beginning October 20, stocks shot up sharply higher (12%). After being out of stocks during the previous downturn, IntelligentValue loaded up on a fresh set of undervalued stocks in the middle of last October for big gains:

Bollinger Bands
CHART 4: Zooming in on Extreme Prices. The October 2014 penetration of the lower Bollinger band, immediately followed by a drop to the green 100-day moving average, identified an excellent set up for buying undervalued stocks. IntelligentValue put that signal to work for big profits.

 

As with other technical indicators, Bollinger Bands are not meant to be used as a stand-alone tool. IntelligentValue uses Bollinger Bands accompanied by basic trend analysis (the moving-average lines) and a proprietary indicator for confirmation. 

ADDING OUR MARKET RISK OSCILLATOR™

A tool we use for confirmation of turnpoints is our proprietary Intelligent Market Risk Oscillator™.  Our Market Risk Oscillator is designed to stay in the 'Bullish Zone' when the market is moving higher (which is about 70% of the time). It is designed to drop below the Bullish Zone when market risk increases. The combination of Bollinger Bands to identify extremes in prices, moving averages to identify trends and support/resistance levels, and our Market Risk Oscillator™ for confirmation of turnpoints makes a powerful combination of indicators. In this table, our Market Risk Oscillator™ is shown in the window below the main chart:

Adding Risk Oscillator
CHART 5: Adding the Intelligent Market Risk Oscillator. After adding our Intelligent Market Risk Oscillator (lower window), we have an unassailable system for identifying market risk.

 

For an example of a non-signal of market risk, notice in the chart above that the Bollinger Band was most recently pierced to the upside in mid-March 2015. Normally, this is where we would begin watching for a 'Market Risk' signal. However, our Intelligent Market Risk Oscillator™ (lower window) did not break below the bullish zone, so a signal did not occur. When we add our Intelligent Market Risk Oscillator™ to the Bollinger Bands and moving-average trendlines discussed previously, we have a very powerful system for identifying periods of market risk that destroy returns and buying opportunities that reap big rewards.

HOW TO PROFIT FROM THE SIGNALS

We formerly sold all of our positions and held cash when we received one of these 'Market Risk' signals. We no longer do this because we have watched a good number of positions continue higher after we exited the market. Many studies have established that about 70% of stocks move in synchronization with the overall market, while 30% do not. In order to avoid selling some of those 30% that continue higher even when the market is headed lower, we now add closing-price stops to each of our value-based stocks when we get a signal of increased market risk. In this way, we can stop out the stocks that go down with the market while continuing to stay invested with the rogue positions that go their own way (higher).

I hope you can see how advantageous it is to have technical analysis in your investing arsenal when you can clearly identify these points of unquestionably evident direction changes. Any investor who looks at stock charts on a regular basis can see that there is nothing random about the stock market. Those big price swings shown in Chart 1 can be harnessed for their upward momentum, while avoiding the big downturns that dramatically reduce portfolio performance.

It is for this reason that we include the Intelligent Market Risk Analysis™ in our weekly updates. Doing so has allowed us to maintain positive returns every year, and our portfolios have beaten their benchmarks by as much as a multiple of 15 times (1500%) since IntelligentValue was launched in 2004.

WHY ARE VALUE STOCKS STRUGGLING?

If it is so easy to identify the signals for when stock indices are headed higher or lower, why have our value-based portfolios struggled in the last year? The reason is that the charts shown above are examples of market-cap weighted indices of small-capitalization stocks, not value-based stocks. If I show you a similar chart of stocks weighted by value, I think you will see the reason almost all value portfolios (not just ours) have been struggling. The chart below shows the Russell 2000 Value Index ($RUJ) for the past two years:

Russell 2000 Value Index
CHART 6: Russell 2000 Value. The Russell 2000 Value Index ($RUJ)shows that small-cap value stocks have met overhead resistance for the last year.

 

 As you can see from this chart, value stocks have struggled mightily since the middle of 2014. Small-cap value stocks gained a return of about 62% in 2013 (compared to 30% for the S&P 500). When one segment of stocks beats the market's benchmark index by more than double, it is only reasonable to assume that segment of stocks would consolidate for a period. However, a full year is a very long consolidation!

The good news is that this value index may be breaking out of that overhead resistance about the 1560 level. As of the time of this writing (Wednesday, June 24) the index has reached a high of 1572 before pulling back and closing back at 1560 again. Hopefully, we will see the index close the week above 1560. If you remember, we only check prices at the end of the close of market each Friday. Intra-week price fluctuations are inconsequential. We will check back with this chart at the end of the day on Friday and see where we stand.  We will report the results for members in this week's Intelligent Market Risk Analysis (IMRA).

It is important to note that the Russell 1000 Value Index ($RLV) has also been in a sideways consolidation since the beginning of 2015! We have previously used the Russell 1000 as the benchmark for our RELATIVE VALUE Portfolio, but if we  instead look at the value version of that index, you will see why our RV portfolio has also been struggling:

Russell 1000 Value Index
CHART 7: The Russell 1000 Value Index ($RLV) shows that small-cap value stocks have met overhead resistance for the last six months.

 

As you can see, mid/large-cap value stocks have been in a consolidation at the 1040 level for the last six months. It is not surprising at all that value portfolios have struggled. The primary culprit for this development is overvaluation. Stocks have gotten ahead of themselves compared to their earnings, cash flow, and book values. However, that should change soon. The end is near!


WHERE ARE STOCKS HEADED NOW?

Based on a variety of different measures, stocks are showing an indication of either being near either a breakout or a significant breakdown. The flatline consolidation that has been in place for small-capitalization stocks since mid-2014, and for mid/large-capitalization stocks since early 2015, is either going to be broken to the upside or there is going to be a major selloff. Either condition will produce profits for our value portfolios!

In fact, we would much prefer to see a substantial selloff in the market. The 'value premium,' i.e., the distance between high-PE 'glamour' stocks and low-PE value stocks, has gotten very tight. We need to see a significant selloff in the market to get the high returns we have experienced in the past. Currently, PEs on small-capitalization stocks are extraordinarily high. 

According to the Wall Street Journal, the PE of the Russell 2000 small-cap index now stands at a whopping 82.68. Unfortunately, the sideways consolidation of the last year has not done much to reduce the PE of this index. Exactly one year ago the PE of the Russell 2000 stood only three points lower at 85.47! What this means is that earnings of the index' companies have not increased at all either in the last year. The only way that prices and PE stay the same is that earnings have not changed.

While the P/E ratio of the S&P 500 stands at a more reasonable 21.73, this is still bubble territory. After six years of a rising market that has seen prices for the largest companies grow by an astonishing 215%, we still have a Federal Reserve with interest rates at zero and the reserve banks of the next two biggest markets (Euro and Japan) still pumping money into the system via QE. Asset prices are at bubble levels, yet policymakers are still holding interest rates as if we are in an emergency. We believe the market is telling us that something is about to break. If it does, the Federal Reserves across the world are out of bullets.

 In this weekend's Intelligent Value Alert newsletter, we will discuss the outcome of this week's market developments and show you why some sectors of the market are screaming that a selloff is forthcoming.  If that happens, our Intelligent Market Risk Analysis™ (IMRA) system will tell us exactly when, and we will be able to make a determination of whether to purchase an inverse ETF to capitalize on the downturn. On the other hand, if there is a breakthrough and continuation to the upside, we will have new recommendations of value stocks that will make the most of the breakout.

In addition to the revisions to our Intelligent Market Risk Analysis (IMRA) charts to use the value versions of the indices, Bollinger Bands and moving averages (as shown in the last two charts on this page), we will do an in-depth expose' on what sector rotation is telling us about where the market is headed. If you want more inside secrets for learning the market's 'truth,' Sunday's newsletter will be for you. In the Stock Analysis section of the Member's Area, we will provide 1-2 more detailed stock analysis summaries and show you why we picked some of the stocks we are currently holding (and possibly have some new picks).



We hope that we have thoroughly discussed the issues in this Value Alert, and you can implement these ideas to your benefit.  Our objective is to give you the best value-oriented investment information possible, with ease of use, timely identification of the issues that affect our portfolio positions, and a full understanding of our approach.  If you have any questions or comments, please contact us with a support ticket.

Best Wishes for Another Week of Intelligent Value Investing,
IntelligentValue.com

 

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DISCLAIMER
Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. Shareholders, employees, and writers associated with IntelligentValue, Inc. may hold positions in the securities that are discussed. If you are not sure if value investing or a particular investment is right for you, we urge you to consult with a Certified Financial Advisor. Neither IntelligentValue.com, nor any of its employees or affiliates are responsible for losses you may incur.